By Nicholas Wesley Yee, CPA
Director of Research at Gradient Analytics
With the 2016 U.S. Presidential Elections coming into the final stretch, Gradient Analytics (a forensic accounting research firm, and a wholly-owned subsidiary of Sabrient Systems) recently published a tax issue commentary for its institutional clients. Included was discussion of the possible impact of each of the two major candidates on the tax code.
The U.S. Tax Code has evolved, in part, as a mechanism to shape economic and political agendas. Similar to the “code” in a computer program, over the years the U.S. Tax Code has experienced numerous modifications, additions, and pet projects of politicians that were built upon the existing code. And similar to a computer program, the continuous accretion of line items to the original code can cause issues that reverberate throughout the entire program. There comes a time when it is more beneficial to scrap the old code and start from scratch so that the entire program can be built harmoniously in nature. While easy enough for a programmer to achieve, the political obstacles that would have to be dealt with in a complete tax code rewrite would likely prove to be too much to overcome. Which leads us to the current presidential candidates and their thoughts on the situation. Read on….
The 2016 U.S. presidential campaign has seen a great deal of focus on corporate taxes both domestically and abroad. While this hot button topic continues to engage both sides of the aisle, definitive plans for reform remain elusive in this political environment. Moreover, the advocated course of action for each candidate implies a great deal of leeway in the application of law and a willingness of the legislature to cooperate. Below is a graphic outlining each candidate’s proposed corporate tax plan and how their proposals would impact the existing Tax Code:
Hillary Clinton plans to use executive authority to punish companies practicing “earnings stripping” and is also calling for a general crackdown on companies attempting to avoid taxes through various tax strategies. Mrs. Clinton intends to achieve this through a reclassification of intercompany debt as equity, effectively removing its tax benefits. She also intends to require a foreign entity purchasing a U.S. firm to control 50% of the combined entity (presently 20%), effectively preventing U.S. companies from merging with a smaller foreign firm to minimize their corporate tax liabilities. Moreover, Mrs. Clinton would go forward with implementation of an “exit tax” to capture undistributed foreign earnings of firms undertaking an inversion. Mrs. Clinton’s inversion reform plan does not explicitly outlaw inversions, but rather makes them a forward-looking managerial decision, which considers both the (higher) costs and benefits of such an action. Additionally, she introduced a plan to incentivize profit sharing by providing a two-year tax credit equal to 15% of the profits shared.
Donald Trump, unlike his opponent, has a specific target for corporate income tax rates. Mr. Trump would like to see the top corporate rate fall to 15%, which would cut 20% from the present statutory rate and place the U.S. a meager 2.5% higher than the inversion friendly 12.5% rate found in Ireland. His plan for indirectly targeting tax inversions is based on his belief that companies leaving the U.S. for lower tax jurisdictions is the symptom rather than the disease. His tax plan also includes a one-time tax holiday wherein repatriation of UFE would be taxed at 10% in conjunction with the termination of foreign earned income tax deferral. His plan calls for the repeal of the alternative minimum tax (AMT). Additionally, his plan also involves a decision for U.S. manufacturers in which the company can elect to expense capital investments or maintain deductibility of corporate interest expenses. This provision would be made once and would become irrevocable after three years. Generally, Donald Trump’s tax plan revolves around closing loopholes and simplifying the application of tax law.
This could affect a number of companies several different ways. A joint statement by the IRS and the Treasury Department opened the conversation of U.S. tax reform anew. As a result, U.S. firms are pursuing “tax inversions” whereby, the company moves its headquarters to a lower tax jurisdiction without substantially changing the underlying operations of the firm.
For example, in early 2015, a high-profile tax inversion was achieved by Allergan (AGN). AGN achieved Irish domiciliation through the acquisition of the smaller Actavis (ACT) (note: the combined company retained the Allergan name and ticker symbol). While both the companies touted the operational efficiencies gained through the combination, it was obvious to most market observers that the potential tax savings was the primary reason for the acquisition.
Notable tax inversion acquisitions in recent years include the following companies:
• Johnson Controls to Ireland (pending)
• Arris Group to the United Kingdom (2016)
• Horizon Pharma to Ireland (2015)
• Mylan to the Netherlands (2015)
• Medtronic to Ireland (2015)
• Burger King to Canada (2014)
The Treasury has taken action twice to make it harder for companies to invert. These actions took away some of the economic benefits of inverting and helped slow the pace of these transactions, but we know companies will continue to seek new and creative ways to relocate their tax residence to avoid paying taxes here at home. Specifically, the Treasury acted to:
• Limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of U.S. companies.
• Address earning stripping by 1) targeting transactions that generate large interest deductions, 2) allowing the IRS on audit to divide debt instruments into part debt and part equity, and 3) finally facilitating improved due diligence and compliance by requiring large corporations to provide up-front due diligence and documentations regarding its related-party financial debt.
It appears for now that corporations may be reluctant to pursue tax inversions over the near-term due to the aforementioned U.S. Treasury statement and increased political scrutiny. However, this does not resolve the current problem of billions of capital being stored overseas. Without a tax holiday, there is a built-in disincentive for U.S. firms to repatriate funds for use in domestic operations. Gradient believes that increasingly global operations of larger U.S. companies with significant foreign cash reserves will lead to a heightened risk of international funds being shifted into high growth markets or to pet projects that need not be carried out domestically. We find that industries reliant on intellectual property for profitability, such as pharmaceuticals and technology firms, are the most aggressive in shifting earnings overseas.
This presidential election could have large ramifications on if/how U.S. public companies address tax inversion. Democratic candidate Hillary Clinton would attempt to make it more difficult by requiring a foreign entity to control 50% of the combined entity, while Republican candidate Donald Trump would attempt to eliminate the benefit by lowering the corporate tax rate. Either way, we expect it will be less likely that companies will benefit from tax inversion in the future.
Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.